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Thursday, February 4, 2010

What should investors do when stock markets turn volatile?

The Sensex is undergoing some volatile movements this week - flat on Monday, down 200 points on Tuesday, up 300 the next, down nearly 300 today - going nowhere in particular.

This is a trying time for investors, who are bewildered about what Mr Market is up to. Is this a good time to buy, or sell, or sit on the sidelines?

Patient, long-term investors are probably waiting for a clear trend to emerge. Die-hard traders may be using this opportunity to make some quick trading profits.

To decide what to do, one must understand the cause of stock market volatility. It is usually caused by uncertainty in the minds of market participants. Uncertainty about what? About the near-term market trend.

We had a long bull rally, which made an intermediate top at 17790 on Jan 6 '10. The index had a sharp 10% (1800 points) fall. Since then it is neither going up, nor falling down. Is this the correction before a new rally, or a pause before a bigger fall? Or, is this the beginning of a sideways consolidation movement?

No one really knows. That is the main reason of anxiety among investors, which is causing the volatility. Jeremy Siegel (author of 'Stocks for the Long Run') has observed in his research that stock markets show a tendency to 'revert to mean'.

The current P/E of the Sensex is above 20, and the mean value is closer to 15. Reversion to mean means a bigger fall should be the logical outcome.

High volatility is usually indicative of a change in trend. That again points to a fall, because the previous trend was up. Most analysts and experts have started suggesting different lower levels for the Sensex.

That can be a contrarian play. When every one agrees that the index will fall, Mr Market tends to do just the opposite.

There are no easy answers to the question - except my favourite one. Forget about the index and remain stock specific. Watch your portfolio like a hawk. If you own some less than stellar scrips which are moving up, book profits.

If you own fundamentally strong stocks that are moving down, don't sell in a hurry. If the fundamentals have not changed for the worse, use the dips to add. If you are in doubt, stay out. Wait for a clearer trend to emerge.

6 comments:

IDFC -SSKI report says "We maintain our 12-month Sensex target at 20000(14x FY11E core earnings and 15x earnings including value ofnon-consolidated subsidiaries)."So though I agree with you that the stock market will revert to the long term mean, what is the fact? Since 9 months results are out we should have a fairly good fix for the Sensex earnings for 2009-10. My guess is that it should be closer to 1100 amd then a 15% increase for 2010-11 takes it to 1265 times 15, then we should look at a figure closer to 18000 precluding any substantial fall from the current level in the short term. Your comments?

Wish stock markets moved on the basis of mathematics and logic! Reversion to mean does happen in the longer term.

But in the short-term, sentiment, liquidity and global cues tend to influence market movements.

We had a one-way rally from 7700 to 17800 without a serious correction. With FIIs pulling out, inflation rising and a tough budget looming on the horizon, a substantial correction could well be on the cards.

I reduced my exposure to certain stocks on the way up. Yes! they did go up 5-10-15% after I sold. I also booked part profits in some of the shares bought in 2008 when they started running up like crazy. That seems to be one of the good ways to go about it. Though one could think about it differently in hindsight later on :)

It's very hard to keep looking at the market and do this. So, I usually stay away, watch from the sidelines and check prices once or twice a week. Life is too vast and interesting to be tied down to the daily vagaries of the stock market :)